By Jay Shareef and Chris Rhoads
There are so many different kinds of retirement plans out there; finding the right one for you can be difficult. With tons of nuance and obscure names, it’s no wonder a lot of people can’t tell the difference from one retirement plan to the next. Two of the most popular types of retirement plans offered by employers are the 401(k) plan and the pension plan.
While it’s unlikely you’ll have to make a choice between the two, since most employers offer one or the other, it’s still vital that you understand how they function and what that means for your retirement. Here’s what you need to know when you come across 401(k)s and pension plans.
What Is a 401(k)?
A 401(k), or defined-contribution plan, is a common retirement plan offered by employers. With a 401(k), you elect to contribute part of your salary into a retirement account. You can choose from a range of investments, such as index funds, mutual funds, and target-date funds. Although you have the ability to change your investments, they are limited to the investments your employer offers. You can contribute up to $20,500 (as of 2022) each year, and if you are age 50 or older, you get an additional $6,500 catch-up contribution.[1] Your employer may also choose to match your contributions up to a certain amount. The total limit for employee and employer contributions is $61,000.
There are two types of 401(k) plans: a traditional 401(k) and a Roth 401(k). In a traditional 401(k), your contribution is taken from your salary pre-tax. Your traditional 401(k) grows tax-deferred, and you only pay taxes when you withdraw from the account in retirement. Because these contributions are tax-deferred, contributing to a traditional 401(k) means you lower your taxable income at the time you contribute.
A Roth 401(k) is funded with money after you’ve already paid taxes on it. The money in your Roth 401(k) grows tax-free in your account, and since you’ve already paid taxes on your contributions, when you withdraw funds, you withdraw them tax-free. Thus, the key difference between the two comes down to when you pay taxes. If your employer offers both, you need to decide whether it makes sense for you to pay taxes now or when you retire. 401(k) plans are also generally subject to required minimum distributions, meaning you’ll need to begin withdrawing from your plan when you reach age 72.[2]
If you are a current federal employee, you can contribute to the Thrift Savings Plan which is similar in structure to a private sector 401(k) plan. Eligible employees receive a matching contribution equal to a maximum of 5% of their gross pay. The matching contribution includes an automatic 1% match (which does not require the employee to make a contribution). Like a 401(k) or IRA, the matching contribution provides additional income, and TSP can be set up with “traditional” (pre-tax) or Roth (after-tax) contributions, and you can also make a combination of both traditional and Roth contributions.
What Is a Pension Plan?
A pension plan, or a defined-benefit plan, is an employer-sponsored plan that guarantees an amount of income in retirement. The amount you receive in retirement is determined by a few factors, such as your length of employment, your salary, your age at retirement, and any other specifications set by the employer.
Your employer is responsible for contributing to the plan and all the investment risk is on them as well. However, you may need to work several years at the organization before you’re eligible for a pension plan. Additionally, with a pension plan you have no control over how it’s invested. Depending on the plan, you may be allowed to contribute part of your salary as well. You are also guaranteed regular payments for the rest of your life, though the plan might offer you the choice of a lump-sum payment.
Which Plan Is Better: 401(k) or Pension Plan?
Both plans have their advantages and disadvantages. Pension plans have been around longer, however, 401(k) plans are much more common today. In fact, as of March 2021, 52% of employees had access to a defined-contribution plan such as a 401(k), while only 3% had access to only a pension plan (12% had access to both).[3] If you have a 401(k), it’s up to you to save for your retirement. You have more control but more responsibility as well. With a pension plan, your employer is responsible for funding the plan. If you like knowing you’ll have a guaranteed income in retirement and prefer not having to contribute any of your own money, a pension plan will be more attractive to you. If you’d rather have more control over how much you put toward retirement, a 401(k) may be a better fit.
Setting Yourself Up for Success
Planning for retirement can feel daunting—but you don’t have to figure it out all by yourself. Choosing the right partner as you plan for the future can help set you up for success in retirement. And finding a financial advisor that understands your unique situation and goals doesn’t have to be difficult.
At WealthFlow Financial, our mission is to simplify navigating the complexities of retirement, helping you plan wisely so you can live fully. We understand that retirement plans are not “one size fits all.” That’s why we work with you to develop a plan tailored to your needs. If you don’t already have an advisor helping you do that, reach out to us at (301) 798-5250 or schedule a phone call now.
About Jay
Jay Shareef is vice president, financial advisor, federal benefits consultant, and co-founder at WealthFlow Financial. As a U.S. Army veteran, Jay is passionate about helping federal employees create a bulletproof plan for retirement and navigate the often confusing and complicated federal benefits landscape. He spends his days educating and providing clients with unbiased insurance benefits and retirement strategies to help his clients create guaranteed income for life. As a problem-solver and trustworthy resource, Jay always puts his clients and their needs first so they can find financial peace of mind. To learn more about Jay, connect with him on LinkedIn.
About Chris
Chris Rhoads is a co-founder and vice president of WealthFlow Financial. As a registered investment advisor and independent financial professional, Chris is committed to helping his clients in retirement and he takes a holistic approach to financial planning that includes insurance and risk management, investments and wealth management, retirement income planning, and estate and tax planning. Chris has been married to his wife, Tia, since 2009 and they live in Frederick, MD, together with their two young daughters. In his free time, Chris enjoys traveling, watching sports, and being active in causes about which he cares passionately. To learn more about Chris, connect with him on LinkedIn.
[1]https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-401k-and-profit-sharing-plan-contribution-limits
[2]https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-required-minimum-distributions-rmds
[3]https://www.bls.gov/opub/ted/2021/67-percent-of-private-industry-workers-had-access-to-retirement-plans-in-2020.htm#:~:text=Bureau%20of%20Labor%20Statistics,-The%20Economics%20Daily&text=Sixty%2Dseven%20percent%20of%20private,to%20defined%20contribution%20retirement%20plans.